Sunday, February 8, 2009

Power disparities and wage differentials

Chris Dillow draws attention to a subtle explanation for the widening wage differential beween employees and executives. The conventional explanation for higher wages has relied on the demand-supply paradigm, and has reasoned that it is required to attract talent. Dillow differs and argues that the real reason is the widening differences in the power exercised over their relative functional jurisdictions/arenas. He attributes this rising inequality to "the result of inequalities in naked power"!

Since the 1980s, technical change has made it easier to monitor ordinary workers, thereby reducing the need to pay them above the market clearing rate and leading to their wage stagnation. In contrast, the power of the executives, especially in financial markets, has increased in proportion to the loosening of control of shareholders over managers and the boom in financial market transactions. This has made it imperative that they be paid more than the market clearing wage so as to incentivize them to not "shirk or damage the company in some way". Dillow writes, "With the costs of shirking so large (especially in competitive and contestable markets), the bribe required to induce effort must also be large."

Describing executive compensation as an agency problem and the result of managerial power, Lucian Bebchuk and Jesse Fried writes, "Boards of publicly traded companies with dispersed ownership cannot be expected to bargain at arm's length with managers. As a result, managers wield substantial influence over their own pay arrangements, and they have an interest in reducing the saliency of the amount of their pay and the extent to which that pay is de-coupled from managers' performance."

As James Kwak writes, "directors like being on boards (it’s a lot of money for not much work, and it’s prestigious), CEOs control who is on the board of directors, CEOs control the information that goes to boards, and board members have weak incentives to act on behalf of the shareholders (they generally don’t own much stock). The only real checks on CEO pay are public outrage (hence the usage of hard-to-understand things like deferred compensation and pension benefits) and large and powerful shareholders." Drawing the distinction between executive compensation in companies and financial market firms, he writes, "while most companies are run for the benefit of a few senior executives, Wall Street firms are unusual in that they are run for the benefit of a large class of professionals. It’s almost a form of sharing the wealth."

It is a different matter that even after paying such huge compensations (or bribes), there is no guarantee that they would not do what they were paid to not do. And as the events of recent months have shown, this is precisely what many executives who ran their banks to the ground, did!